Accounting Theory and Analysis

11th Edition

Solutions Manual

By

Richard G. Schroeder
University of North Carolina at Charlotte

Myrtle W. Clark
University of Kentucky

Jack M. Cathey
University of North Carolina at Charlotte

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 4 Page 1
 CHAPTER 4

Case 4-1

Investors wish to use accounting information to minimize risk and to maximize returns.
The capital asset pricing model (CAPM) is an attempt to deal with both risks and return.
The rate of return to an investor from buying a common stock and holding it for a period
of time is calculated by adding the dividends to the increase (or decrease) in value of the
security during the holding period and dividing this amount by the purchase price of the
security or

dividends + increase (or - decrease) in value

purchase price

Some risk is peculiar to the common stock of a particular company. For example, a
company's stock may decline in value because of the loss of a major customer such as
the loss of Hertz as a purchaser of rental cars by the Ford Motor Company. On the
other hand, overall environmental forces cause fluctuations in the stock market that
impact on all stock prices such as the oil crisis in 1974. These two types of risk are
termed unsystematic risk and systematic risk. Unsystematic risk is that portion of risk
peculiar to a company that can be diversified away. Systematic risk is the
nondiversifiable portion which is related to overall movements in the stock market and is
consequently unavoidable.

As securities are added to a portfolio unsystematic risk is reduced. Empirical research

has demonstrated that unsystematic risk is virtually eliminated in portfolios of 30-40
randomly selected stocks. However, if a portfolio contains many common stocks in the
same or related industries, a much larger number of stocks must be acquired.

An additional assumption of the CAPM is that investors are risk averse; consequently,
investors will demand additional returns for taking additional risks. As a result, high risk
securities must be priced to yield higher expected returns than lower risk securities in the
marketplace.

A simple equation can be illustrated to express the relationship between risk and return.
This equation uses the risk free return (the Treasury Bill rate) as its foundation and is
stated:

Rs = Rf + Rp

Where:

Rs = The expected return on a given risky security

Rf = The risk free rate

Rp = The risk premium

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 Since investors can eliminate the risk associated with acquiring a particular company's
common stock by acquiring diversified portfolios, they are not compensated for bearing
unsystematic risk. And, since well diversified investors are only exposed to systematic
risk, investors using the CAPM as the basis for acquiring their portfolios will only be
subject to systematic risk. Consequently, the only relevant risk is systematic risk and
investors will be rewarded with higher expected returns for bearing market-related risk
that will not be affected by company specific risk.

The measure of the parallel relationship of a particular common stock with the
overall trend in the stock market is termed Beta (β). β may be viewed as a
gauge of a particular stock's volatility to the volatility of the total stock market.

A stock with a β of 1.00 has a perfect relationship to the performance of the overall
market as measured by a market index such as Dow-Jones Industrials or the Standard
and Poor's 500 - stock index. Stocks with a β of greater than 1.00 tend to rise and fall by
a greater percentage than the market; whereas, stocks with a β of less than 1.00 are
less likely to rise and fall than is the general market index. Therefore β can be viewed
as a particular stock's sensitivity to market changes, and as a measure of systematic
risk.

Case 4-2

a. In the supply and demand model, price is determined by (1) the availability of the
product (price) and (2) the desire to possess that product (demand). The assumptions
of this model are:

1. All economic units possess complete knowledge of the economy.

2. All goods and services in the economy are completely mobile and can be easily
shifted within the economy.

3. Each buyer and seller must be so small in relation to the total supply and demand
that neither has an influence on the price or demand in total.

4. There are no artificial restrictions placed on demand, supply, or prices of goods and
services.

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b. The securities market is considered the best example of the supply and demand model
because stock exchanges provide a relatively efficient distribution system and
information concerning securities is available through many different outlets.

c. The efficient markets hypothesis holds that the price of a security is determined by the
purchaser's knowledge of available relevant information about that security. According
to this theory, the market for securities can be described as efficient if it reflects all
available information and reacts instantaneously to new information. The three forms of
the efficient market hypothesis differ in their definitions of all available information as
follows:

Weak form - Available information consists of past price history of the security.

Semi-strong form - Available information includes past price history and all other
publicly available information.

Strong form - Past price history, all publicly available information and insider
information.

Case 4-3

a. Calendar anomalies are related with particular time periods i.e. movement in stock prices
from day to day, month to month, year to year etc. Following are examples of calendar
anomalies:
Calendar anomalies Description

Stock prices are likely to fall on Monday;

1. Weekend Effect: consequently, the Monday closing price is
less than the closing price of previous
Friday.

The prices of stocks are likely to increase on

2. Turn-of-the-Month Effect: the last trading day of the month, and the
first three days of next month.

The prices of stocks are likely to increase

3. Turn-of-the-Year Effect during the last week of December and the
first half month of January

Small-company stocks tend to generate

greater returns than other asset classes and
4. January Effect: the overall market in the first two to three
weeks of January.

For many years, it has been argued that value strategies outperform the market. Value
strategies consist of buying stocks that have low prices relative to earnings, dividends,

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 the book value of assets or other measures of value. Following are examples of value
anomalies:

Value anomalies Description

Stocks with low market price to book value

ratios generate greater returns than stocks
1. Low Price to Book having high book value to market value
ratios.

Stocks with high dividend yields tend to

2. High Dividend Yield outperform low dividend yield stocks.

Stocks with low price to earnings ratios are

3. Low Price to Earnings (P/E)
likely to generate higher returns and
outperform the overall market, while the
stocks with high market price to earnings
ratios tend to underperform the overall
market.

Prior neglected stocks tend to generate

higher returns than the overall market in
4. Neglected Stocks subsequent periods of time. While the prior
best performers tend to underperform the
overall market.

Technical analysis is a general term for a number of investing techniques that attempt to
forecast security prices by studying past prices and other related statistics. Common
technical analysis techniques include strategies based on relative strength, moving
averages, as well as support and resistance. Following are examples of technical
anomalies

Technical anomaly Description

A trading strategy which involves buying

stocks when short-term averages are higher
1. Moving Average than long-term averages and selling stocks
when short-term averages fall below their
long-term averages.

A trading strategy which is based upon

resistance and support levels. A buy signal is
2. Trading Range Break created when the prices reaches a
resistance level. A selling signal is created
when prices reach the support level.

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 There are also several other types of anomalies that cannot be easily categorized.
Examples of these anomalies are:

Other Anomalies Description

1. The Size Effect Small firms tend to outperform larger firms.

Price changes tend to persist after initial

2. Announcement Based Effects and announcements. Stocks with positive
Post-earnings Announcement Drift surprises tend to drift upward, those with
negative surprises tend to drift downward.

Stocks associated with initial public offerings

3. IPO's, Seasoned Equity Offerings,
and Stock Buybacks
(IPOs) in tend to underperform the market
and there is also evidence that secondary
offerings also underperform. Whereas,
stocks of firms announcing stock
repurchases outperform the overall market in
the following years.

There is a relationship between transactions

by executives and directors in their firm's
4. Insider Transactions stock and the stock's performance. These
stocks tend to outperform the overall market.

Stocks rise immediately after being added to

5. The S&P Game S&P 500

b. Behavioral finance explores the proposition that investors are often driven by emotion
and cognitive psychology rather than rationale economic behavior. It suggests that
investors use imperfect rules of thumb, preconceived notions, bias-induced beliefs and
behave irrationally. Consequently, behavioral finance theories attempt to blend cognitive
psychology with the tenets of finance and economics to provide a logical and empirically
verifiable explanation for the often observed irrational behavior exhibited by investors.
The fundamental tenet of behavioral finance is that psychological factors, or cognitive
biases, affect investors, which limits and distorts their information and may cause them
to reach incorrect conclusions even if the information is correct.

c. Some of the most the most common cognitive biases in finance are:
Mental accounting - The majority of people perceive a dividend dollar differently from a capital
gains dollar. Dividends are perceived as an addition to disposable income; capital gains
usually are not.

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Biased expectations - People tend to be overconfident in their predictions of the future. If
security analysts believe with an 80% confidence that a certain stock will go up, they are
right about 40% of the time. Between 1973 and 1990, earnings forecast errors have
been anywhere between 25% and 65% of actual earnings.

Reference dependence - Investment decisions seem to be affected by an investor’s reference

point. If a certain stock was once trading for $20, then dropped to $5 and finally
recovered to $10, the investor’s propensity to increase holdings of this stock will depend
on whether the previous purchase was made at $20 or $5

Representativeness heuristic. In cognitive psychology this term means simply that people
tend to judge “Event A” to be more probable than “Event B” when A appears more
representative than B. In finance, the most common instance of representativeness
heuristic is that investors mistake good companies for good stocks. Good companies are
well-known and in most cases fairly valued. Their stocks, therefore, may not have a
significant upside potential.

Case 4-4

The deductive approach to the development of a theory begins with the establishment of
certain objectives. Once the objectives have been identified, key definitions and
assumptions are stated. the researcher then develops a logical structure for
accomplishing the objectives, based on the definitions and assumptions. Political
economy theory is an example of deductive theory formation in that it stresses that the
objective of accounting should not be the benefit of one group over another and
recommends viewing market and socio-economic forces in the development of
accounting theory. Agency theory is also a normative theory in that it attempts to
explain behavior.

The inductive approach to the development of a theory emphasizes making observations

and drawing conclusions from those observations. It is going from the specific to the
general. Under this approach the researcher generalizes about the universe based
upon a number of observations of specific situations. APB Statement No. 4 was an
example of inductive research in that it described GAAP on the basis of observations
about current practice.

The pragmatic approach to theory development is based on the concept of utility or

usefulness. That is, once a problem has been identified, the researcher attempts to find
a utilitarian but not necessarily a optimum solution. A Statement of Accounting Theory

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 by Sanders, Hatfield and Moore was an example of the pragmatic approach to theory
development in that it essentially recommended to accountants "do what you think best."
This study was used by some accountants as an authoritative source that justified
current practice.

Case 4-5

The basic assumption of agency theory is that individuals maximize their own expected
utilities. It attempts to explain behavior in terms of the benefit to be derived from a
particular course of action. Inherent in agency theory is the assumption that there is a
conflict of interest between the owners of a firm (shareholders) and the managers
because managers are maximizing their own utilities which does not result in a
maximization of shareholder wealth. An agency is defined as a relationship by consent
between two parties whereby one party (agent) agrees to act on behalf of the other party
(principal). According to agency theory, the political process has an impact on agency
relationships because political officials frequently believe that inefficient markets can
only be remedied by government intervention. Agency theory may help to explain the
absence of a comprehensive theory of accounting because of the diverse interests
involved in financial reporting; however, it will not help to identify the correct accounting
procedures because it only attempts to explain the state of current practice not the best
methods of practice.

Case 4-6

Studies attempting to assess an individual's ability to use information are termed human
information processing research. In general this research has indicated that individuals
have a limited ability to process large amounts of information. The main consequences
of this finding are:

1. An individual's perception of information is selective. That is, since individuals are

capable of comprehending only a small part of their environment, their anticipation of
what they expect to perceive about a particular situation will determine to a large
extent what they do perceive.

2. Since individuals make decisions on the basis of a small part of the total information
available, they do not have the ability to make optimal decisions.

3. Since individuals are incapable of integrating a great deal of information, they

process information sequentially.

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 If these conclusions are correct, the current focus on disclosure by the FASB may have
an effect opposite to what is intended. That is, the annual reports may already
contain more information than can be processed by individuals.

Case 4-7

a. Critical perspective research rejects the view that knowledge of accounting is grounded
in objective principles. Rather researchers adopting this viewpoint share a belief in the
indeterminacy of knowledge claims. This indeterminacy view rejects the notion that
knowledge is externally grounded and is only revealed through systems of rules that are
superior over other ways of understanding phenomena. These researchers attempt to
interpret the history of accounting as a complex web of economic, political and
accidental co-occurrences. They have also argued that accountants have been unduly
influenced by one particular viewpoint in economics (utility based, marginalist
economics). This economic viewpoint holds that business organizations trade in
markets that form a part of a society's economy. Profit is the result of these activities
and is indicative of the organization's efficiency in using society's scarce resources. In
addition, these researchers maintain that accountants have also taken as given the
current institutional framework of government, markets, prices and organizational forms
with the result that accounting serves to aid certain interest groups in society to the
detriment of other interest groups.

b. Critical perspective research views mainstream accounting research as being based

upon the view that there is a world of objective reality that exists independently of human
beings which has a determinable nature that can be observed and known through
research. Consequently, individuals are not seen as makers of their social reality,
instead they are viewed as possessing attributes that can be objectively described (i.e.
leadership styles or personalities). The critical perspectivists maintain that mainstream
accounting research equates normative and positive theory. That is, what is and what
ought to be are the same. It is also maintained that mainstream accounting research
theories are put forth as attempts to discover an objective reality, and there is an
expressed or implied belief that the observed phenomena are not impacted by the
research methodology. In summary, mainstream accounting research is based upon a
belief in empirical testability.

c. In contrast, critical perspective research is concerned with the ways societies, and the
institutions that make them up, have emerged and can be understood. Research from
this viewpoint has been claimed to be based on three assumptions:

1. Society has the potential to be what it is not.

2. Conscious human action is capable of molding the social world to be something

different or better.

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 3. No. 2 can be promoted by using critical theory.

Case 4-8

a. No. Financial reporting should be neutral. According to SFAC No. 5, neutrality means
that in either formulating or implementing accounting standards, the primary concern
should be the relevance and reliability of the information being provided, not the effect
that the accounting standards will have on a particular interested party. That is,
accounting information should be free from bias toward a predetermined result.
Neutrality implies that accounting information reports economic activity and financial
position as faithfully as possible without attempting to influence behavior in some
particular direction. Accounting information that is not neutral loses credibility.

Employers who provide postretirement and postemployment benefits presumably do so

because the employees earned these benefits while they worked. If so, these costs
accrue during the employment period. When they are accounted for, accrual or pay-as-
you-go, does not affect the amount and timing of the future payments. Management
decisions should be based on how they affect cash flows, i.e., their economic impact, not
on how accountants report economic events.

b. Arguably, there are social costs associated with the accounting for postemployment and
postretirement benefits. If management reacts to the accounting change be curtailing
benefits, the cost is real and obvious. Employees will not receive benefits as they did
before. Other possible costs might include agency costs such as management
compensation or debt covenant agreements. If management’s compensation is based
on net income, expensing the cost of providing these benefits early will reduce net
income and management’s bonus. Reporting previously unreported liabilities for future
benefit payments would negatively affect debt-to-equity ratios that may be perceived by
the stock market as increased risk and may violate existing debt covenant agreements.

c. Critical perspective proponents would argue that the social costs (see b.) outweigh the
benefits, if any, of reporting postemployment benefits and postretirement benefits in
accordance with the new pronouncements.

d. Mainstream accounting proponents would argue that the role of accounting is to report
unbiased information. Accounting should report economic circumstances and events as
they are and should not present information to achieve a particular result. They would
argue that not to report the information required because of potential social costs would
be to present financial information that was biased and thus not neutral, thereby violating

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 the neutrality concept. They would also argue that the user needs to know the potential
cost of these benefits and therefore reporting them in accordance with the new
pronouncements is relevant to user decision making.

Case 4-9

a. Liabilities are defined as probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events. Capital leases meet this
definition, hence they represent claims to resources.

Liabilities are to be measured at the present value of future cash flows discounted at the
effective rate of interest. This measurement requirement is consistent with the
accounting of capital leases. Investors, creditors and other users recognize liabilities as
requiring the use of cash in the future, hence, reporting liabilities at the present value of
future cash flows provides information for user predictions of future cash outflows. While
it is true that reporting the anticipated future cash flows in footnotes would also provide
users with information to predict future cash flows, simultaneous reporting of the present
value of those future cash flows as a liability on the balance sheet underscores the fact
that there is a present claim to company resources.

Also, lease capitalization reports an asset that was essentially purchased. This
treatment is consistent with that of other purchased assets. The leased asset provides
the same services as a purchased asset. It will provide future benefit over its useful life
or the lease term and hence meets the definition of an asset. Reporting its value as an
asset meets the conceptual framework’s objective of providing information regarding a
company’s resources. Simply listing the expected future lease payments in a footnote
tends to obscure the fact that there is an asset and that the asset provides future benefit
which presumably will be associated with future cash inflows.

b. The semi-strong form of the EMH implies that all publicly available information is
impounded in security prices. Since the cash flows are the same whether the lease is
capitalized or not, and those cash flows would be public information regardless of
whether the lease were capitalized or described in the footnotes, the market would
instantaneously impound the information into the stock prices in the same way under
either accounting approach as soon as the information became public.

c. Agency theory would predict that managers would choose accounting procedures that
would increase assets, increase earnings, or decrease debt. The higher debt is to equity

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 the more likely the company will breach existing debt covenants. Management is
expected to act in a manner that would reduce associated agency costs. Lease
capitalization would increase assets, but it would also increase debt. Hence, agency
theory would predict that management would have a tendency to structure lease
agreements so that the debt would not be reported on the balance sheet - i.e.,
management would not want to capitalize leases.

FASB ASC 4-1 Employee Stock Options

Information on stock compensation is contained in FASB ASC 718-10. It can be

accessed through the expense topic field or by searching share based payments.

Room for Debate

Debate 4-1 The efficient market hypothesis and accounting information

Team 1 Given the EMH, argue that accounting is relevant

The three forms of the efficient market hypothesis (EMH) are the weak form, the semi-
strong form, and the strong form. According to the weak form, the historical price of a
stock provides an unbiased estimate of the future price of the stock. Hence, an investor
cannot make excess gains by knowledge of prior prices. But, an investor could gain if
he/she has other knowledge regarding expected future performance of a company, e.g.,
accounting information. Under this form of the EMH, accounting information is definitely
relevant.

According to the semi-strong form of the EMH, all publicly available information is
instantaneously impounded into security prices. Hence, publicly available information,
such as publicly released accounting information is already reflected in the price of a
share of stock, and knowledge of this information would not provide an advantage to any
potential investor. In this case only insider information, e.g., accounting information
which is not released to the public, would benefit the potential investor. Yet there are
restrictions on insider trading of stocks.

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 Nevertheless, insider information is still useful for other purposes. It is used for planning
and strategy for the corporation. It is used in labor negotiations. It is used for the
preparation of income tax returns. Many users use the information

According to the strong form of the EMH, all information is impounded into security
prices. Under this theory, even insiders could not benefit from knowledge of nonpublic
information. But accounting information would still be useful to lenders, and a host of
other users.

Team 2 Given the EMH, argue that accounting information is irrelevant

The three forms of the efficient market hypothesis (EMH) are the weak form, the semi-
strong form, and the strong form. According to the weak form, the historical price of a
stock provides an unbiased estimate of the future price of the stock. Hence, an investor
cannot make excess gains by knowledge of prior prices. Under this form of the EMH it is
not possible to argue that accounting information is irrelevant. An investor could gain if
he/she has other knowledge regarding expected future performance of a company, e.g.,
accounting information. Under this form of the EMH, accounting information is definitely
relevant.

According to the semi-strong form of the EMH, all publicly available information is
instantaneously impounded into security prices. Hence, publicly available information,
such as publicly released accounting information is already reflected in the price of a
share of stock, and knowledge of this information would not provide an advantage to any
potential investor. If this is so, investors would not have information that is not publicly
available and accounting information would be irrelevant. They could do just as well
picking stock randomly.

According to the strong form of the EMH, all information is impounded into security
prices. No information, even accounting information which is not available to the public,
would provide an advantage to any investor over other investors. Hence, accounting
information would not be relevant.

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Debate 4-2 Critical perspective versus mainstream accounting

Team 1 Present arguments supporting critical perspectives research.

Critical perspectives proponents argue that accounting is not objective. Rather, the
accounting procedures and standards resulted from a complex web of economic,
political, and accidental co-occurrences. For example, the recent pronouncements
related to accounting for fair value and accounting for stock options created pressure on
Congress to interfere in the standard setting process. Similarly the pronouncement on
loan impairments created outside pressures for the FASB to promulgate accounting
rules taking the present value of future cash flows into consideration. The result is that
debtors and creditors of impaired loans, in particular troubled debt restructures, account
for the same economic event in different ways. It is difficult to explain how this kind of
accounting asymmetry provides information that is representationally faithful and
therefore objective.

Critical perspectives proponents also argue that accounting has been unduly influenced
by utility based, marginalist economics. That is, the profit motive is all that matters. This
viewpoint overlooks many other goals of business organizations, such as social goals.
In addition they argue that accountants aid profit oriented groups to the detriment of
others.

Critical perspectives proponents view organizations in both a historic and a societal

context. Accordingly, accounting should serve the good of society as well as business
organizations. It should concern itself with the powerful multinational corporation and
how these corporations affect the benefits received by and the costs to society. For
example, accounting reports should provide information regarding the social costs of
polluting the environment.

Team 2 Arguments supporting traditional mainstream accounting research

Traditional mainstream accounting research is concerned with unbiased, objective

reporting of results of economic transactions and events. Accounting serves a
stewardship function for investors, creditors and other users. Because the modern
corporation is characterized by separation of management and ownership, accounting
has a responsibility to owners to report how management has utilized the resources

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 entrusted to it and how the company has actually performed during the accounting
period.

Accounting does have a duty to society. But, that duty is not to try to cause corporations
to provide benefit to the society at large. Rather, in a free market economy, business
serves society by providing goods and services to the public. In return, business
provides a return to owners, jobs for societies people, and profits to other businesses by
buying goods and services from them. It is the accountant's job to report on these
activities so that users of accounting information can assess the value of the company.
It is not the accountant’s job to pass judgment on the activities themselves or to bias
reporting so that a societal goal can be reached.

Debate 4-3 Positive versus normative accounting theory

Team 1Support reliance on positive theory to develop a general theory of accounting

Proponents of the positive theory of accounting maintain that it provides a description of

existing accounting practice. In fact, this theory has arisen because existing theoretical
constructs do not fully explain accounting practice. Stated differently, positive theory
explains what is, rather than what should be. Thus, it can be used to explain why
companies make the accounting choices that they do.

Positive accounting can be associated with the contractual view of the firm in which
accounting practices have evolved to mitigate contracting costs by establishing
agreement among varying parties. For example, a positivist would say that
conservatism has origins in the contract markets, including managerial compensation
contracts and lender debt contracts. To prove their point, one would argue that, absent
conservatism, managerial compensation agreements may reward managers based on
current performance that may later prove unwarranted.

According to Watts and Zimmerman, positive accounting theory should help us to better
understand the sources of pressures that drive the accounting standard-setting process
and how accounting standards affect individuals and individual behavior and thus the
allocation of resources. According to the theory, managers of firms make accounting
choices because of their own self interests. If we can better understand how accounting
standards affect management, then we can do a better job of writing standards to help
bring about appropriate, rather than dysfunctional management behavior. If we don’t
know how accounting standards will be used, then it is unlikely that the goals of
transparency and better reporting will be achieved.

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 Positive, not normative accounting theory, explains observed accounting practice.
Unlike normative accounting theory it does not rely on consensus of accounting
professionals. Because there is no set of goals that is universally accepted by
accountants, normative accounting theory development may not provide appropriate,
practical accounting standards. Thus, since normative accounting theories rely upon
acceptability, the resulting theoretical development may be suspect.

Team 2 1Support reliance on normative theory to develop a general theory of accounting

Normative accounting theory is based on sets of goals which prescribe the way financial
reporting should be, not just how it is. If we do not know what we should be reporting,
how can we expect to develop accounting standards whose use will produce financial
reports that can be relied upon to present the true financial picture of the reporting
entity?

Accountants typically agree with the Conceptual Framework’s goal of providing decision-
relevant financial information to users. Decision-relevant financial reports provide the
user with information which they can use to predict future performance and to compare
companies. Only accounting standards that are based on what ought to be are likely
provide management with a consistent choice and application of accounting policies so
that reported results are unbiased and transparent. Accounting standards derived from
normative theory can result in financial statements that are consistent across time and
among companies. Knowledge of how managers can use accounting information to bias
financial results is useful, but does not provide accountants with what they need to
prepare decision-relevant financials.

Accounting standards should be based on clearly stated objectives that can be used to
derive logical and consistent principles and practices. Just because there is no
universally accepted set of objectives, does not mean that there should not be. There is,
at least, a relatively wide acceptance of the underlying objectives and assumptions
outlined in the FASB’s Conceptual Framework. These assumptions can certainly be
relied upon to aid in the development of logical and consistent accounting standards.
We can use these objectives and assumptions to logically derive accounting standards
using a deductive approach. In other words, deduction, based on agreed upon
assumptions, is an appropriate approach to accounting theory development. This is the
normative approach.

WWW

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Case 4-10

a. Agency relationships involve costs to principals. Agency costs have been defined as the
sum of (1) monitoring expenditures incurred by principals to control the behavior of
agents, (2) bonding expenditures incurred by the agent, and (3) the residual loss.
Monitoring expenditures include such costs as costs of measuring and observing the
agent’s behavior and the costs of establishing compensation schemes that would tend to
provide incentives to the agent to realign personal goals to be closer to those of
principals. Bonding expenditures are incurred by the agent to guarantee that he will not
take certain actions to harm principal’s interest or that he will compensate the principal if
he does. The wealth effect caused by a difference between actions taken by the agent
and what the principal would have the agent take. Because individuals are expected to
take actions to maximize their own utility, managers and shareholders are expected to
incur monitoring and bonding costs as long as these costs are less than the residual
loss.

b. An increase in debt would increase agency costs. An increase in debt would increase
interest expense and lower income to stockholders. It would also increase the debt-to-
equity ratio and thus would be perceived as increasing risk. Increase in risk may
increase the cost of debt via increased interest rate.

c. To reduce risk, debt-holders often restrict the amount of debt a company can issue, by
putting a limit on the company’s debt-to-equity ratio. The debt covenants are a bonding
cost that reduce the cost of debt.

Case 4-11

The primary goal of accounting information is to provide investors with

information that is relevant and faithfully represents economic phenomena so
they can make informed investment decisions. Individual investors make the
following investment decisions:
 Buy—a potential investor decides to purchase a particular security on the
basis of available information.
 Hold—an actual investor decides to retain a particular security on the
basis of available information.
 Sell—an actual investor decides to dispose of a particular security on the
basis of available information.
Individual investors use all available financial information to assist in acquiring or
disposing of the securities contained in their investment portfolios that are
consistent with their risk preferences and the expected returns offered by their
investments. One of the methods available to investors to make these decisions
is fundamental analysis. Fundamental analysis is an attempt to identify individual
securities that are mispriced by reviewing all available financial information.
These data are then used to estimate the amount and timing of future cash flows
offered by investment opportunities and to incorporate the associated degree of

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 4 Page 17
 risk to arrive at an expected share price for a security. This discounted share
price is then compared to the current market price of the security, thereby
allowing the investor to make buy–hold–sell decisions.

Case 4-12

The students will have different answers to this case depending on the companies
selected and the time period chosen.

Financial Analysis Case

The students will have different answers to this case depending on the companies
selected.

Financial Accounting Theory & Analysis: Text and Cases

Solutions Manual, Chapter 4 Page 18